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Chapter 3. Working With Financial Statements. Chapter Organization. Cash Flow and Financial Statements: A Closer Look Standardized Financial Statements Ratio Analysis The Du Pont Identity Using Financial Statement Information Summary and Conclusions.
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Chapter 3 Working With Financial Statements Chapter Organization Cash Flow and Financial Statements: A Closer Look Standardized Financial Statements Ratio Analysis The Du Pont Identity Using Financial Statement Information Summary and Conclusions Corporate Finance 1
Hermetic, Inc. Balance Sheet Hermetic, Inc. Balance Sheet as of December 31 ($ in thousands) Assets 1998 1999 Current Assets Cash $ 45 $ 50 Accounts receivable 260 310 Inventory 320 385 Total $ 625 $ 745 Fixed assets Net plant and equipment 985 1100 Total assets $1610 $1845 Corporate Finance 2
Hermetic, Inc. Balance Sheet (concluded) Liabilities and equity 1998 1999 Current liabilities Accounts payable $ 210 $ 260 Notes payable 110 175 Total $ 320 $ 435 Long-term debt 205 225 Stockholders’ equity Common stock and paid-in surplus 290 290 Retained earnings 795 895 Total 1085 1185 Total liabilities and equity $1610 $1845 Corporate Finance 3
Hermetic, Inc., Income Statement ($ in thousands) Net sales $710.00 Cost of goods sold 480.00 Depreciation 30.00 Earnings before interest and taxes $200.00 Interest 20.00 Taxable income 180.00 Taxes 53.45 Net income $126.55 Dividends $ 26.55 Addition to retained earnings 100.00 Corporate Finance 4
Statement of Cash Flows • Operating activities • + Net income • + Depreciation • + Any decrease in current assets (except cash) • + Increase in accounts payable • – Any increase in current assets (except cash) • – Decrease in accounts payable • Investment activities • + Ending fixed assets • – Beginning fixed assets • + Depreciation Corporate Finance 5
Statement of Cash Flows (concluded) • Financing activities • – Decrease in notes payable • + Increase in notes payable • – Decrease in long-term debt • + Increase in long-term debt • + Increase in common stock • – Dividends paid Corporate Finance 6
Hermetic, Inc. Statement of Cash Flows • Operating activities • + Net income + $ 126.55 • + Depreciation + 30.00 • + Increase in payables + 50.00 • – Increase in receivables – 50.00 • – Increase in inventory – 65.00 $ 91.55 • Investment activities • + Ending fixed assets +$1,100.00 • – Beginning fixed assets – 985.00 • + Depreciation + 30.00 ($ 145.00) Corporate Finance 7
Hermetic, Inc. Statement of Cash Flows (concluded) • Financing activities • + Increase in notes payable + $ 65.00 • + Increase in long-term debt + 20.00 • – Dividends – 26.55 $58.45 Putting it all together, the net addition to cash for the period is: $91.55 – 145.00 + 58.45 = $5.00 Corporate Finance 8
Hermetic, Inc. Common-Size Balance Sheet Assets 1998 1999 Current Assets Cash 2.8% 2.7% Accounts receivable 16.1 16.8 Inventory 19.9 20.9 Total 38.8% 40.4% Fixed assets Net plant and equipment 61.2% 59.6% Total assets 100% 100% Corporate Finance 9
Hermetic, Inc., Common-Size Balance Sheet (continued) Liabilities and equity 1998 1999 Current liabilities Accounts payable 13.0% 14.1% Notes payable 6.8 9.5 Total 19.9% 23.6% Long-term debt 12.7% 12.2% Stockholders’ equity Common stock and paid-in surplus 18.0% 15.7% Retained earnings 49.4 48.5 Total 67.4 64.2 Total liabilities and equity 100% 100% 10
Hermetic, Inc., Common-Size Balance Sheet (concluded) More on Standardized Statements Suppose we ask: “What happened to Hermetic’s net plant and equipment (NP&E) over the period?” 1. Based on the 1998 and 1999 B/S, NP&E rose from $985 to $1100, so NP&E rose by $115 (a use of cash). 2. If we standardized the 1999 numbers by dividing each by the 1998 number, we get a common base year statement. In this case, $1100/$985 = 1.117, so NP&E rose by 11.7% over this period. 3. Did the firm’s NP&E go up or down? Obviously, it went up, but so did total assets. In fact, looking at the standardized statements, NP&E went from 61.2% of total assets to 59.6% of total assets. 4. If we standardized the 1999 common size numbers by dividing each by the 1998 common size number, we get a combined common size, common base year statement. In this case, 59.6%/ 61.2% = 97.4%, so NP&E fell by 2.6% as a percentage of assets. (..) In absolute terms, NP&E is up by $115, or 11.7%, but relative to total assets, NP&E fell by 2.6%. Which is more relevant? . Corporate Finance 11
Hermetic, Inc. Common-Size Income Statement Net sales 100.0 % Cost of goods sold 67.6 Depreciation 4.2 Earnings before interest and taxes 28.2 Interest 2.8 Taxable income 25.4 Taxes 7.5 Net income 17.8 % Dividends 3.7 % Addition to retained earnings 14.1 % 12
Things to Consider When Using Financial Ratios • What aspect of the firm or its operations are we attempting to analyze? • Firm performance can be measured along “dimensions” • What goes into a particular ratio? • Historical cost? Market values? Accounting conventions? • What is the unit of measurement? • Dollars? Days? Turns? • What would a desirable ratio value be? What is the benchmark? • Time-series analysis? Cross-sectional analysis? Corporate Finance 13
Categories of Financial Ratios • Short-Term Solvency, or Liquidity • Ability to pay bills in the short-run • Long-Term Solvency, or Financial Leverage • Ability to meet long-term obligations • Asset Management, or Turnover • Intensity and efficiency of asset use • Profitability • The ability to control expenses • Market Value • Going beyond financial statements Corporate Finance 14
Common Financial Ratios I. Short-Term Solvency, or Liquidity, Ratios Current assets Current ratio = Current liabilities Quick ratio = (Current assets - inventory) / Current liabilities Cash ratio = Cash / Current liabilities Current assets Interval measure = Average daily operating costs Corporate Finance 15
Common Financial Ratios (continued) II. Long-Term Solvency, or Financial Leverage Ratios Total assets - Total equity Total debt ratio = Total assets Debt/equity ratio = Total debt/Total equity Equity multiplier = Total assets/Total equity Long-term debt Long-term debt ratio = Long-term debt + Total equity EBIT Times interest earned ratio = Interest EBIT + depreciation Cash coverage ratio = Interest 16
Common Financial Ratios (continued) III. Asset Utilization, or Turnover, Ratios Cost of goods sold Inventory turnover = Inventory 365 days Days’ sales in inventory = Inventory turnover Sales Receivables turnover = Accounts receivable 365 days Days’ sales in receivables = Receivables turnover Sales NWC turnover = NWC Sales Fixed asset turnover = Net fixed assets Sales Total asset turnover = Total assets Corporate Finance 17
Common Financial Ratios (continued) IV. Profitability Ratios Net income Profit margin = Sales Net income Return on assets (ROA) = Total assets Net income Return on equity (ROE) = Total equity Corporate Finance 18
Common Financial Ratios (concluded) V. Market Value Ratios Price per share Price-earnings ratio = Earnings per share Market value per share Market-to-book ratio = Book value per share Corporate Finance 19
The Du Pont Identity 1. Return on equity (ROE) can be decomposed as follows: ROE = Net income/Total equity = Net income/Total equity X Total assets/Total assets = Net income/Total assets X Total assets/Total equity = _____________ X Equity multiplier 2. Return on assets (ROA) can be decomposed as follows: ROA = Net income/Total assets X Sales/Sales = Net income/Sales X Sales/Total assets = ______________ X _______________ Corporate Finance 20
The Du Pont Identity (concluded) 3. Putting it all together gives the Du Pont identity: ROE = ROA X Equity multiplier= Profit margin X Total asset turnover X Equity multiplier 4. Profitability (or the lack thereof!) thus has three parts: • Operating efficiency • Asset use efficiency • Financial leverage Corporate Finance 21
Chapter 3 Quick Quiz Wal-Mart, Venture Stores, and KMart collectively represent the majority of sales in the discount retail industry in this country. The following data are from quarterly financial statements filed with the SEC and retrieved from the SEC website. ROEWal-Mart = (.0276)(.6578)(2.463) = .0447 Current share price = $ 26.875 52 week high share price = $28.25 ROEVenture = (-.0116)(.4474)(3.073) = -.0159 Current share price = $ 3.25 52 week high share price = $8.50 ROEKMart = (.0041)(.5276)(2.534) = .0055 Current share price = $ 9.75 52 week high share price = $14.25 Which firm is the market leader? Do you think its ROE is the cause or the result of its leadership position? The two secondary firms have not performed as well as the leader. In what area(s) have they done particularly poorly? 22